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Foreclosures: For novices, it's a crapshoot

The allure of foreclosed properties to a would-be real estate investor is nearly irresistible: Buy valuable properties for pennies on the dollar with little or no risk of your own money, work when you feel like it, and grow rich.

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Countless seminars and how-to books promise to turn even the most novice buyer into a high-powered real estate investor through the magic of foreclosed homes. The trouble is the dream of instant, safe, trouble-free wealth often turns out to be like most things that sound too good to be true -- a scam. If easy money was to be made, everyone would be getting rich off of foreclosures.

True, some people do, just like some people get rich in the stock and commodities markets, oil wells and foreign currencies. But, just like these other forms of investing, profitably buying and selling real estate takes research, knowledge, experience, money and time. And nearly every deal with a huge profit potential also comes with an appropriately sized risk.

Beyond get-rich-quick seminars and informational classes offered by nonprofit agencies and local sheriff's offices, few, if any professionals are available or willing to teach novice investors the ins and outs of foreclosure sales. Why should they show you how to buy a great property at a deep discount instead of doing the deal themselves?

Still, if you are willing to go it alone and invest the time and cash required to deal in foreclosures, your first step should be to understand the process as thoroughly as possible.

The basics
Foreclosure is the legal method by which lenders or governmental agencies take properties from owners who fail to make payments, and then resell those homes to recoup money owed them.

Nonpayment of a mortgage or home equity loan is the most common reason a home gets foreclosed, but it is far from the only reason. But people could also be facing a foreclosure because of a balloon payment, not paying property taxes, not carrying enough insurance, or even failing to keep the property in good working condition, says Rande Johnsen, a trustee for Trustee Corps in Irvine, Calif.

There are three distinct phases of foreclosures, each with its own advantages and each fraught with peril.

The 3 phases of foreclosure:
Preforeclosure: The time between when the homeowner has stopped making payments and when the land is actually put up for sale at auction. Investors take this opportunity to deal directly with the homeowner.
Auction: When the courts seize the property from the homeowner and sell it to the highest bidder. The county sheriff or a trustee handles this process, depending on the state.
REO: If the property fails to sell at auction, or if the lender ends up as the highest bidder, the home becomes "real estate owned" (REO) by the bank. Banks then try to sell these REO properties on the open market, often through a real estate agent or third-party marketing company.

Often these homes are sold to buyers who don't even know they are buying a foreclosure and go through the entire process as they would with any other home.

Going once ...
The typical foreclosure is literally bought on the county courthouse steps during a sheriff's auction or a trustee's sale. These auctions are typically held on a weekday morning, and bidders must come to the sale armed with information and flush with cash or its equivalent. Plastic, personal checks and IOUs are almost universally shunned at auction and, depending on where you live, investors usually must make a sizable deposit or pay the entire sum on the spot, says John T. Reed, editor of Real Estate Investor's Monthly newsletter and author of the book "How to Buy Real Estate For At Least 20% Below Market Value."

Details vary widely by state, but as a rule, prospective buyers are not allowed inside the house before bidding begins. This is a frightening concept for many buyers, who must lay down thousands of dollars in cash upfront without knowing anything about the home beyond what is available through basic public records searches and a curbside appraisal.

The house could be infested with termites, gutted to the rafters by previous residents or filled with lead paint or asbestos, and a buyer wouldn't know until after the sale is final.

This as-is aspect of auctions is only part of what can make foreclosures so perilous for beginning buyers. Another is that these homes can never be guaranteed to come with a clear title.

Next: " ... foreclosures are particularly problematic"
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